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Nov 20, 2014

3Q2014 Update: Opportunity Equity

Samantha McLemore

Market Overview

The S&P 500 Index reached new highs in the third quarter, ending with a total return of 1.13% for the quarter. The Nasdaq Composite beat it, rising 1.93%, and the Dow Jones Industrial Average rose 1.29% for the quarter. Five of the 10 sectors in the S&P 500 posted positive returns during the period. Health care and information technology were the biggest outperformers, with returns of 5.03% and 4.34%, respectively. Large-cap stocks outperformed mid-cap stocks, which beat small-cap names. Specifically, the Russell 1000 Index’s 0.65% gain surpassed the negative returns of both the Russell MidCap Index and the small-cap Russell 2000 Index, which posted -1.66% and -7.36%, respectively, for the quarter. Growth stocks beat their value counterparts, as the Russell 1000 Growth Index rose 1.49%, compared with the -0.19% return of the Russell 1000 Value Index over the same period.

The S&P 500 and the Nasdaq Composite completed their seventh straight quarter of gains, with the 6.7% YTD gain of the S&P 500 remaining above the median nine-month gain since 1926 of 6.1%. The stock market continued to reach new highs despite continued geopolitical conflict. Fighting continued in Ukraine, with the downing of Malaysian Airlines flight MH17 over eastern Ukraine. Russia’s involvement in Ukraine was met with increased sanctions from the U.S. and EU. The conflict with ISIS continued in Iraq and spread into Syria, calling for international action. The U.S. and U.K. targeted airstrikes were met with retaliatory beheadings of U.S. and U.K. hostages by ISIS. The U.S. has organized a coalition to help battle ISIS in Iraq and Syria. During the quarter, conflict also broke out between Israel and Palestine, sparking a 50-day Gaza war instigated by the death of three missing Israeli teenagers at the end of June. Ebola also became a major point of focus, as the epidemic in West Africa continued to worsen, with three Americans being brought back to the States for treatment. The quarter came to an end with Scotland voting against a referendum to leave the U.K.

Japan and the United States were the strongest regions in the ACWI, with only seven out of 14 countries in Europe posting gains. Japan rose 5.10%, along with India, which continued to increase, by 4.36% over the quarter, after its recent elections. Russia saw a decline of -6.89%, after its rebound in the second quarter, due to the increased conflict in Ukraine.

Strategy Highlights

During the third quarter of 2014, Opportunity Equity generated a total return of -4.03% (net of fees)1. In comparison, the strategy’s unmanaged benchmark, the S&P 500 Index, returned 1.13% for the same period.

The portfolio initiated one position and eliminated nine during the quarter, ending the quarter with 62 holdings, where the top 10 represented 34.90% of total assets, compared with 17.9% for the index, highlighting Opportunity Equity’s meaningful active share2 of around 93%.

Top Contributors:

    • The Apple C71.48 1/15 Calls were up 34.32% during the quarter as Apple’s new product lines were announced and hit stores. Apple unveiled their new Apple Watch, which will be available in early 2015 along with the new iPhone 6 and 6 Plus. Apple also introduced Apple Pay, which will allow it to enter into the payments space. The first weekend sales for the new phones were up 11.1% YoY and show promise for a strong product cycle. Apple’s F3Q14 revenue was slightly below Street expectations with a beat on EPS of $1.28 vs. $1.23 while maintaining a strong gross margin of 39.4%. Apple continues to see small declines in their iPad sales, with a belief that the new larger iPhone 6 Plus could possibly cannibalize the market.

    • Gilead Science Inc. (GILD) increased over the quarter, rising 28.4%. Gilead’s second-quarter results surpassed expectations, topping Q2 revenue forecasts of $5.9B by $0.6B, which supported its strong performance. Gilead is continuing to see upside from its launch of Sovaldi and expects strong demand to continue. In addition, Gilead bought back $1.2B of stock in Q2 and plans to buy back another $1.7B in Q3, with another $5B authorized.

    • United Continental Holdings (UAL) bounced back after its rough end to the second quarter to finish out with an increase of 13.93% in the third quarter. The improvement in performance was supported by the strong performance in Q2 with an EPS beat of $0.09 at $2.34 on better cost performance. United gained 6% PRASM domestically over the second quarter and is expected to continue to improve. United is now focused on improving revenue management while also increasing ancillary revenue. Although they are still facing integration hurdles causing them to underperform on margin, United is poised to continue their improvements. Over the quarter, United announced that Linda Jojo would become their new Executive Vice President and Chief Information Officer, replacing Bob Edwards who is retiring.

Bottom Contributors:

    • Genworth Financial Inc. (GNW) had a rough second quarter, decreasing by -24.71%. Genworth’s second-quarter results missed estimates with EPS missing by $0.04. The Long Term Care unit experienced unfavorable developments over the quarter, which was the major cause of the poor performance. As a result, Genworth announced that they will be conducting a comprehensive review of the LTC claim reserves. In addition, James Boyle, the CEO of the U.S. Life unit since January, stepped down as CEO. McInerney, the CEO, will take over the U.S. Life unit, in addition to his other duties. Although the LTC business performed poorly over the quarter, the U.S., Canada and Australia mortgage insurance segment had strong numbers.

    • Monitise PLC (MONIF) was down -41.55% for the quarter as it continues to try to become EBITDA positive. Over the quarter, Monitise reduced its FY14 revenue guidance to $95- 97mm, versus the prior guidance of $102mm; however, it still expects to make EBITDA positive in FY16. Their second-quarter results missed prior guidance but revenue still increased 31%. The miss is associated with renegotiating some license contracts to subscription as a result of their move from license to SaaS-based subscription contracts which was announced in March. Over the quarter, Monitise announced a multi-year strategic global alliance with IBM, building on their existing relationship that was announced last year. However, this news was dampened by Visa’s announcement that it is reassessing its investment in Monitise and is looking to create the same capabilities in house. With Visa being Monitise’s largest customer, with a contract that expires in 2016, this is worrying for investors.

    • Intrexon Corp (XON) was down -26.06% for the quarter, even with strong revenues. Revenues of $11.8mm were $2mm above consensus for the second quarter, while EPS of -$0.53 was $0.35 below consensus, missing on investments. Cost recoveries improved over the period, with recoveries having met or exceeded 50% of operating expenses, which will help accelerate ECC progress. Over the quarter, Intrexon acquired Trans Ova, a leading provider of bovine reproductive technologies, for $90M, which will broaden Intrexon’s reach in animal health and productivity. Intrexon also appointed Keith Canada, Ph.D., as Vice President during the period.

1For more detailed annualized performance information, please click here. Past performance is no guarantee of future results. LMM LLC claims compliance with the Global Investment Performance Standards (GIPS). Click here for the Opportunity Equity GIPS Disclosure document.

2Active share represents the share of portfolio holdings that differs from the benchmark index holdings. The greater the difference between the asset composition of the portfolio and its benchmark, the greater the active share.

Contact LMM to obtain information on how Top and Bottom Contributors were calculated and/or to obtain a list showing every holding's contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this commentary reflect those of LMM LLC (LMM) portfolio manager(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading on behalf of any portfolio. Any data cited is from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. References to particular securities are intended only to explain the rationale for the portfolio manager's action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

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